IBF - Updates - 2007 (Q4 v2.0)

Copyright © 2008 by Institute of Business & Finance. All rights reserved. v2.0

INSTITUTE OF BUSINESS & FINANCE

QUARTERLY UPDATES

Q4 2007

Quarterly Updates

Table of Contents

MUTUAL FUNDS

MUTUAL FUND DIRECTORS 1.1

MORNINGSTAR RATING SYSTEM 1.1

TARGET-DATE FUNDS AND FOREIGN EXPOSURE 1.2

VALUE VS. GROWTH 1.2

STEWARDSHIP RANKINGS 1.2

AFTER-TAX PERFORMERS 1.3

MULTIPLE ASSET CLASS INVESTING 1.4

MUNICIPAL BOND DEFAULT RATE 1.6

INTERNATIONAL EQUITIES 1.7

MAKING A CASE FOR UTILITIES 1.7

STRUCTURED NOTES 1.8

30 YEARS OF WITHDRAWALS 1.10

RETIREMENT

MORNINGSTAR’S 401(K) PLAN 2.1

FUND FAMILY MANAGER RETENTION RATES 2.1

529 PLANS VS. ROTH IRAS 2.2

ANNUITIES

INCOME ANNUITIZATION 3.1

ONLINE ANNUITY RESOURCES 3.1

IMPROPER ANNUITY CONTRACT STRUCTURE 3.2

REAL ESTATE

GNMA ISSUES REVERSE MORTGAGE BONDS 4.1

REVERSE MORTGAGE CHOICES 4.1

REIT WEBSITES 4.2

REAL ESTATE LOSSES 4.3

REAL ESTATE GAINS 4.3

CLOSED-END FUNDS

CLOSED-END FUND FACTS 5.1

COVERED CALL CEFS 5.1

ETFS

MUNICIPAL BOND ETFS 6.1

ETN RUSH 6.1

FREE ETF AND MUTUAL FUND TOOLS 6.2

FOREIGN BOND ETFS 6.3

MISC.

NO OIL SHORTAGE 7.1

HEDGE FUND TRADING 7.1

FUND CURRENCY HEDGING 7.2

CORPORATE PROFITS 7.2

PRESCRIPTION DRUG COVERAGE 7.2

RATING HOSPITAL CARE 7.3

LONGER LIFE EXPECTANCY 7.4

QUARTERLY UPDATES

MUTUAL FUNDS

1.1 MUTUAL FUNDS

QUARTERLY UPDATES

IBF | GRADUATE SERIES

1.MUTUAL FUND DIRECTORS

Mutual fund directors can negotiate lower fees for shareholders, fire fund managers, and

merge a fund into another. Directors also oversee the valuation of hard-to-price securities

and 12b-1 fees. Fund directors must also assess their own performance, explain their

reasons for approving advisory contracts, and have policies designed to prevent securities

law violations.

Fund boards typically meet 4-5 times a year; the median director compensation for the

largest fund families was $172,000, according to a Management Practice survey. A third

of the directors surveyed said they spend more than 50 hours per quarter on board work.

A study by Binghamton University and Cornell University found that funds that received

good Morningstar governance grades outperformed those with bad grades by 1.2 to 1.9

percentage points a year between late 2004 and the end of 2006. Another study indicated

that more independent boards have less patience with poorly performing funds and are

more likely to merge them with other funds.

MORNINGSTAR RATING SYSTEM

The Morningstar star rating system is a way advisors and investors can easily see a

mutual fund’s long-term risk-adjusted performance over the past three-, five-, and 10-

years. Each fund is compared to its category (vs. a broader asset-class that was used until

2002). Thus, a small cap value fund is now compared to other small cap value funds. The

system is based on the assumption that at any given risk level, investors are happy to

reduce their risk level in return for less return potential (vs. the old rating system which

looked only at a single point on the risk/reward curve). Funds that charge a commission

are penalized under the star rating system.

At the end of June each year, Morningstar does a comparison to see how accurate their

ratings have been. Generally, 5-star funds have slightly outperformed 4-star funds, 4-star

funds have slightly outperformed 3-star offerings, and so on. When you compare 5-star

with 1-star funds, the differences become noticeable. For example, for the 5-year period

ending 6/30/2007, 5-star domestic stock funds beat their 1-star peers by 1.5% annualized;

in the case of foreign stock funds, the difference was 0.90% per year difference. The

ratings for the past five years have worked best for balanced funds, where a 5-star rating

resulted in an average performance advance of 3.1% annualized over 1-star balanced

funds. Taxable bond funds rating 5-star outperformed 1-star funds by 0.7% per year;

1.1% in the case of municipal bond funds. Morningstar also looked at expense ratios,

“Funds that are both 5-star and low cost have a significantly lower standard deviation

than those that are just five stars.”

MUTUAL FUNDS 1.2

QUARTERLY UPDATES


TARGET-DATE FUNDS AND FOREIGN EXPOSURE

Even though about half the value of the world’s total stock market value is outside the

U.S., few advisors would feel comfortable with such a high exposure for their clients.

Two areas that target-date funds have been criticized are too little exposure to equities

(given the multi-decade time horizon of their typical investor) and not having enough

foreign exposure. Ibbotson Associates recommends a 30% international weighting for

long-term investors; Vanguard suggests 20% of the portfolio should be overseas, while

Fidelity is closer to 25%, Putnam is around 30%, and AllianceBernstein is above 35%.

VALUE VS. GROWTH

According to the book, “What Works on Wall Street,” from 1963 to 2005, high p/e stocks

returned 6.9% a year, compared with 15.0% for low p/e stocks. The book’s author, James

O’Shaughnessy, points out that low price-to-sales stocks returned 5.6% versus 2.6% for

their high price-to-sales peers. From 1927 to 2006, large cap value stocks returned 12.0%

a year, compared to 9.1% for large cap growth, while small cap value returned 14.8% a

year versus 9.6% for small cap growth. For the period 1927 to 2004, value stocks

returned 12.5% a year versus 9.0% for growth stocks, based on price to book value,

according to Morningstar.

STEWARDSHIP RANKINGS

Morningstar ranks mutual fund families in five areas (corporate culture, fund manager

incentives, board of directors oversight, fees, and regulatory history) to arrive at

Stewardship Grade. Of the five criteria, “corporate culture” counts for up to four of the

10 possible points a fund family can receive. Regulatory compliance receives zero points,

but can count for up to two negative points if a family ignores its regulatory obligations.

The October 2007 table below shows the fund families that have the highest stewardship

ratings; the number of funds in the family are shown in parentheses.

1.3 MUTUAL FUNDS

QUARTERLY UPDATES


2007 Stewardship Grades

Fund Family Grade Fund Family Grade

Clipper (1) A FPA (5) B

Davis/Selected (7) A Vanguard (96) B

Dodge & Cox (4) A Primecap (3) B

Diamond Hill (3) A American Funds (24) B

T. Rowe Price (69) B Royce (11) B

AFTER-TAX PERFORMERS

When deciding whether or not to use an index fund or ETF, one of the considerations is

its performance compared to a benchmark, on a before and after tax basis. The table

below shows the percent of active domestic stock fund managers who have outperformed

their respective index on a before tax and after tax basis. The results were based on 10-

year annualized figures (1987-2006). The figures shown in parentheses represent the

percentage of actively-managed U.S. stock funds that have outperformed their benchmark

on an after tax basis.

Active Management vs. Index [1997-2006]

Value Blend Growth

Large Cap 15% (4%) 31% (14%) 63% (44%)

Mid Cap 13% (0%) 46% (16%) 54% (30%)

Small Cap 35% (7%) 81% (53%) 82% (69%)

As you can see, the chances of a fund manager outperforming its value benchmark on an

after-tax basis ranges from 0-7%, while the odds of a small cap growth or blend active

manager having better after-tax returns ranges from 53% to 69%. This means that over

the past 10 years, the vast majority of advisors interested in value stocks would have been

better off using an index fund or ETF.

MUTUAL FUNDS 1.4

QUARTERLY UPDATES


MULTIPLE ASSET CLASS INVESTING

A study by Roger Gibson covering the 25-year period from 1986 to the end of 2005

shows the benefits of structuring client portfolios using multiple asset categories,

particularly real estate and commodities. A quote from Talmud (circa 1200 B.C.-500

A.D.) supports this view: “Let every man divide his money into three parts, and invest a

third in land, a third in business, and a third let him keep in reserve.” As of the end of

2005, the world’s total investable capital market was valued at $93.4 trillion, according to

UBS Global Asset Management. As you can see, the U.S. represents close to half the

world’s investable capital (25.5% + 16.9% + 6.2% + a portion of “cash equivalents”).

$93.4 Trillion Capital Market Breakdown [12-31-2005]

U.S. Bonds 25.5% Cash Equivalents 4.1%

Non-U.S. Bonds 21.5% Emerging Market Bonds 2.9%

Non-U.S. Stocks 20.7% Emerging Market Stocks 1.8%

U.S. Stocks 16.9% Private Markets 0.3%

U.S. Real Estate 6.2%

The Gibson study which looks at every 25-year rolling period ending 1997 through 2005,

includes a number of exhibits that can be summarized as follows:

[A] For every 25-year period, a pure long-term bond portfolio has the least amount of risk

when its composition is 70% in U.S. corporate bonds and 30% in foreign bonds, almost

always resulting in slightly lower returns. However, in all cases, when the foreign bond

exposure was increased from 0% to 10%, 20% or 30%, the small loss in returns was more

than offset by a correspondingly higher percentage drop in risk.

[B] Stock diversification into foreign equities usually resulted in a lower standard

deviation; an increase from 20% to 30% in foreign stocks made virtually no difference.

Thus, historically the advisor did not increase or decrease risk or reward by altering the

international equity weighting from 20% to 30% or from 30% to 20%. However, adding

foreign stocks to a pure U.S. stock portfolio did decrease risk by 1-7%, usually adding

nothing or little to annualized returns. Specifically, over every 25-year period, portfolio

volatility was lower with a foreign equity allocation of 10% or 20%; in almost every 25-

year period, volatility was also lower with a 30% allocation to international stocks.

1.5 MUTUAL FUNDS

QUARTERLY UPDATES


[C] Looking at every possible 1-4 asset class portfolio (U.S. stocks, foreign stocks, real

estate securities, and commodities) and reviewing every 25-year rolling period from 1972

to the end of 2005: (1) two-asset portfolios generally had less risk and better returns than

single asset portfolios; (2) three-asset portfolios had better risk/return characteristics than

two asset class portfolios; and (3) the four-asset-class portfolio (25% in U.S. stocks, 25%

in foreign stocks, 25% in real estate securities, and 25% in commodities) had less risk

than any combination of 1-3 asset classes (except an equal weighting in U.S. stocks, real

estate securities, and commodities) and a higher annualized return (over 13%) than most

combinations.

As an example, a portfolio with an equal weighting in all four asset classes had a return

very similar to a 100% investment in real estate securities (which was the number one

performer over the 25-year rolling periods) but with 1/3rd

less risk. This is quite a surprise

since the other three asset classes (U.S. stocks, foreign stocks, and commodities) had

lower returns and more volatility than real estate securities.

The table below shows the returns of the 15 equity portfolios described in “[C]” above

for all 25-year rolling periods from 1972 through 2005 (note: U = U.S. stocks, F =

foreign stocks, R = real estate securities, and C = commodities). All of the annualized

return figures have been rounded off to the nearest ½%, with the exception of the Sharpe

Ratio, which was rounded off to the nearest 1/10th

).

Returns and Risk for 15 Different Equity Portfolios [1972-2005]

Portfolio Return Portfolio Std. Dev. Portfolio Sharpe

RC 14.0% URC 11.0% URC 0.7

FRC 13.5% UFRC 11.5% FRC 0.7

URC 13.5% FRC 12.0% UFRC 0.7

R 13.5% UFC 13.0% RC 0.6

UFRC 13.5% UC 13.0% UR 0.6

FC 13.0% RC 13.5% UFC 0.6

FR 13.0% UR 14.5% UR 0.5

UR 13.0% UFR 15.0% FC 0.5

UFR 13.0% FC 15.5% R 0.5

UR 12.5% FR 15.5% FR 0.5

UFR 12.5% R 16.5% UFR 0.5

C 12.0% U 17.5% UF 0.4

UF 11.5% UF 17.5% U 0.4

F 11.5% F 22.0% C 0.3

U 11.0% C 24.5% F 0.3

MUTUAL FUNDS 1.6

QUARTERLY UPDATES


Returns and Risk for 1-4 Asset Portfolios [1972-2005]

Portfolio Return Portfolio Std. Dev. Portfolio Sharpe

4 assets 13.5% 4 assets 11.5% 4 assets 0.7



1 asset 12.0% 1 asset 20.0% 1 asset 0.4

As you can see from the summary table above, the four-asset-class portfolio had the

highest returns, the least risk, and the best Sharpe Ratio. This table clearly shows the

advantages of asset class diversification. The final table below shows the five worst

calendar years during the 1972-2005 period for each of the four asset classes as well as a

portfolio with an equal weighting in each (U.S. stocks, foreign stocks, real estate

securities, and commodities). As you can see, there is a huge difference between a single

asset category portfolio and one with all four asset classes.

Five Worst Years [1972-2005]

U.S. Stocks Foreign Stocks R.E. Securities Commodities Equal Allocation

-26% (1974) -23% (1990) -21% (1974) -36% (1998) -13% (2001)

-22% (2002) -22% (1974) -18% (1998) -32% (2001) -8% (1974)

-15% (1973) -21% (2001) -16% (1973) -23% (1981) -6% (1981)

-12% (2001) -16% (2002) -15% (1990) -17% (1975) -3% (1990)

-9% (2000) -14% (1973) -5% (1999) -14% (1997) -1% (1998)

MUNICIPAL BOND DEFAULT RATE

Between 1970 and 2006, only 41 municipal bonds defaulted. The default rate for the 10-

year period 1997-2006 was just 0.1%, versus a 0.5% default rate for AAA-rated corporate

bonds and 2.1% for investment-grade bonds, according to Moody’s. According to a

PIMCO report, high-yield municipal bonds had a 16% correlation to stocks and a 41%

correlation to high-yield corporate bonds over the 10 years ending September 2006.

1.7 MUTUAL FUNDS

QUARTERLY UPDATES


INTERNATIONAL EQUITIES

Since 1975, adding foreign stocks (MSCI EAFE Index) has almost always produced a

diversification benefit, lowering volatility over three-year holding periods. Historical data

indicates that the average returns and volatility for the EAFE Index and S&P 500 have

been very similar when looking at the period 1971 through 2005. For example, during

this time period, the S&P 500 averaged 12.1% per year and had a standard deviation of

16%, while the EAFE averaged 12.6% with a standard deviation of 17%.

MAKING A CASE FOR UTILITIES

Utility funds are often ignored by advisors and brokers, yet, this conservative sector asset

category can add needed portfolio diversification, a proven stream of comparatively high

dividends, and total return figures that rival the S&P 500, with similar risk. For example,

the table below compares annualized returns for large cap blend with utility funds.

Large Cap Blend Funds vs. Utility Funds

[periods ending December 31st, 2007]

3 year 5 year 10 year 15 year

Utility Funds 21.5% 11.5% 10.2% 9.7%

Large Cap Blend Funds 10.1% 6.0% 7.7% 9.9%

A desired effect of adding any asset category is the hope of reduced portfolio volatility, a

result of either a lower correlation coefficient or the risk characteristics of the investment

itself. Surprisingly, the standard deviation for utility funds is slightly greater than that of

large cap blend or value funds (8 vs. 7), but lower than large cap growth funds (10 vs. 8),

even though utilities have a much lower beta (0.6 vs. 1.0 for large cap blend and 1.3 for

large cap growth funds).

MUTUAL FUNDS 1.8

QUARTERLY UPDATES


With an R-squared of just 25 (vs. 85 for large cap blend funds and 100 for the S&P 500),

it is easy to see the possible diversification benefits. Moreover, such diversification is

needed now that it appears the correlation coefficient between blend, growth, and value

domestic funds is quite high, as shown in the table below.

Correlation to the S&P 500

[3 years ending 6/30/07]

Value Blend Growth

Large 0.97 0.99 0.94

Mid 0.90 0.90 0.87

Small 0.84 0.84 0.83

For the 15-year period ending 6/30/2007, utility funds had a 0.34 correlation to the S&P

500 (vs. 0.15 for gold, 0.51 for energy, and 0.28 for REITs). Over these same 15 years,

the S&P 500 experienced 60 months of negative returns; utility funds outperformed the

S&P 500 60% of time when the S&P 500 had a negative month.

STRUCTURED NOTES

Structured products usually combine some type of downside protection along with some

degree of upside potential. Typically, a structured note uses derivatives to either add or

remove risk from a specific asset such as a stock, market index, commodity, or currency.

During the 2006 calendar year, U.S. investors bought over $64 billion of these products

(vs. over $190 billion in Europe), a 32% increase from the previous year. There are three

basic types of structured notes: principal protection notes, enhanced yield products, and

reverse convertibles; the AMEX website defines 54 different subsets of the structured

products it trades in.

Principal Protection Notes PPNs offer investors equity exposure without risk to principal. These notes usually have a

five year maturity and 100% market participation along with 100% principal protection.

For example, a Merrill Lynch note that tracks the S&P 500, the Nikkei 225, and the Euro

50 indexes guaranteed a minimum return of at least 5% along with FDIC insurance.

1.9 MUTUAL FUNDS

QUARTERLY UPDATES


The correlation between U.S. stocks and other developed stock markets has generally

been higher during U.S. bear markets. Yet, even when the correlation is high,

international investing may provide the short-benefit of higher returns, as during most

U.S. bear markets, or lower volatility, as during the technology bubble. As you can see

from the table below, even excluding the 1987 Crash, the returns of the S&P 500 and

EAFE Index has generally been high during bear markets.

S&P 500 and EAFE Correlation

1971-2005 1971-1986 1988-2005

Bear Bull Bear Bull Bear Bull

65% 47% 52% 39% 75% 54%

During six of the eight U.S. bear markets since 1971, a 20% allocation to EAFE stocks

provided an average 2.2% greater return and just 0.7% less volatility than 100% invested

in the S&P 500. During bull markets during this same period, a 20% EAFE weighting

resulted in 0.8% less return and 1% lower volatility.

MUTUAL FUNDS 1.10

QUARTERLY UPDATES


30 YEARS OF WITHDRAWALS

Suppose you have clients who believe their remaining life expectancy is 30 years and

have little or no donative intent. With a goal of structuring a portfolio that will least 30+

years, given a consistent annual withdrawal amount (meaning no adjustment for

inflation), the table below shows the odds of obtaining that goal.

The table below shows the odds of someone not outliving their nest egg using different

withdrawal rates. All of the percentage figures, which range from 72% to 100% are based

on Monte Carlo probability analysis using stock, bond, and cash equivalent indexes over

the past 25-80 years (20 years in the case of EAFE stocks and 80 years in the case of all

other asset categories). The 5,000 simulations done to obtain these percentages (odds of

success) did not factor in any expense ratios or other costs associated with a brokerage or

mutual fund account.

— Annual Withdrawal Rate —

3% 4% 5% 6%

Asset Mix

S&P 500….100%

Long-term corporate bonds….0%

99% 98% 95% 89%

S&P 500….50%


100% 99% 98% 93%

S&P 500….50%


100% 99% 92% 72%

S&P 500….28%

EAFE Index….12%


Cash (90-day T-bills)….20%

100% 100% 99% 94%

QUARTERLY UPDATES

RETIREMENT

2.1 RETIREMENT

QUARTERLY UPDATES


2.MORNINGSTAR’S 401(K) PLAN

The table below shows the mutual funds that Morningstar uses for their own 401(k) plan,

as of the third quarter of 2007. Funds that include “**” indicate a portfolio weighting of

15-20%, a “*” means a weighting of 3-8% (note: it appears that no fund has a weighting

of 9-14%).

American Beacon Small Value (AVPAX) * T. Rowe Price High-Yield (PRHYX)

American Funds New World (NEWFX) T. Rowe Price Small-Cap Stock (OTCFX) *

Brandywine (BRWIX) Tweedy, Browne Global Value (TBGVX) *

Harbor Capital Appreciation (HACAX) ** Vanguard Institutional Index (VINIX)

Oakmark Select (OAKLX) ** Vanguard FTSE Social Index (VFTSX) *

PIMCO Real Return Insl (PRRIX) * Vanguard International Growth (VWIGX) **

PIMCO Total Return (PTTRX) Vanguard LifeStrategy Growth (VASGX)

Primecap Odyssey Agg. Growth (POAGX) * Vanguard Selected Value (VASVX) *

Selected American D (SLADX)

FUND FAMILY MANAGER RETENTION RATES

Mutual fund advisory firms generally agree that performance and manager retention are

closely related. Fund companies that have a high retention rate are usually near the top

when it comes to peer group performance. Similarly, funds near the bottom when it

comes to retention are often poor performers. The table below shows the five-year

average manager retention rate of 24 of the largest mutual fund families, for the period

2002-2006). The retention rate was determined by looking at who was listed as a fund

manager of a fund within a family at the beginning of the year and then seeing if that

person was still listed as a manager of the fund at the end of the year (note: if a manager

stayed with the parent company but was no longer listed as the fund’s manager, it was

still considered a departure).

RETIREMENT 2.2

QUARTERLY UPDATES


2007 Fund Manager 5-Year Retention Rate

95-100% retention 85-89% retention

Dodge & Cox PIMCO

American Funds Van Kampen

T. Rowe Price Columbia

90-94% retention Fidelity

Janus ING

Vanguard AIM

Oppenheimer John Hancock

Franklin Temnpleton Principal Investors

Hartford BlackRock

American Century 79-84% retention

GMO MFS

AllianceBernstein JP Morgan

DWS-Scudder

Putnam

529 PLANS VS. ROTH IRAS

A Roth IRA may be a better alternative to a 529 Plan when it comes to funding a child’s

education. Withdrawals from a Roth IRA are tax-free and penalty-free whenever it is

used to fund higher education, versus restrictions for 529 Plan withdrawals. The biggest

advantage of a 529 Plan is that it is funded with pre-tax dollars, while a Roth IRA uses

after-tax dollars; the biggest advantage the Roth has is that its flexibility is much greater.

QUARTERLY UPDATES


QUARTERLY UPDATES

ANNUITIES

3.1 ANNUITIES

QUARTERLY UPDATES


3.INCOME ANNUITIZATION

A 2007 study by Wharton and New York Life Insurance shows that an income annuity

can provide an income stream for life at a cost of as much as 40% less than a traditional

stock, bond, and cash mix. Phrased another way, the study shows that someone who

needs a $1 million next egg can maintain the same lifestyle by purchasing a $600,000

lifetime annuity. A 65-year-old male will receive about $86,000 a year, while $1 million

invested in a traditional securities portfolio would generate $40,000-$50,000 annually,

depending on the withdrawal rate.

Even though a 65-year-old man is expected to live to age 85, about half of these men will

live well past age 85, some may even reach 100. Retirement income planning tends to

“break down” for those that live longer than expected, according to Wharton School

Professor David Babbel and Brigham Young Professor Craig Merrill, the two authors of

the study. According to Babbel, “The best strategy is to invest enough in an annuity early

in retirement to cover basic fixed costs. That allows you to invest the remainder of your

portfolio more aggressively.” The Wharton study is available at investmentnews.

com/retirementcenter/annuities.

ONLINE ANNUITY RESOURCES

The following online sources can help you determine if a client should invest in annuities

and, if so, how much:

immediateannuities.com

Instant quotes for monthly payouts from immediate fixed-rate annuities

longevityalliance.com

Describes different types of annuities and sends quotes, via email or telephone, for

immediate annuities.

incomesolutions.com/annuityfaq.asp

Answers basic questions about immediate fixed-rate annuities.

ANNUITIES 3.2

QUARTERLY UPDATES


sec.gov/investor/pubs/varannty.htm

The SEC publication, “Variable Annuities: What You Should Know.”

naic.org/documents/consumer_alert_annuities_senior_citizens.htm

The National Association of Insurance Commissioners description of the different types

of annuities, whether annuities are the right choice, and warnings about deceptive sales

practices.

IMPROPER ANNUITY CONTRACT STRUCTURE

According to Advanced Sales Corp. (ASC), from 2002 to 2006, 38% of variable annuity

contracts were improperly structured (who should be the owner, annuitant and

beneficiary). The most common shortcoming has been not naming any beneficiary. The

second most common mistake was naming someone as beneficiary other than the person

who was intended to inherit the contract, usually the client’s spouse. There are over 600

different variable annuity contracts. Four simple rules to keep in mind are: [1] every

annuity pays out when any contract owner dies, unless spousal continuation is allowed;

[2] with an owner-driven contract, the death of annuitant means nothing—there is no

death benefit payout; [3] with an annuitant-driven contract and the sole annuitant dies, the

contract must pay out; and [4] every rule can have an exception.

QUARTERLY UPDATES

REAL ESTATE

4.1 REAL ESTATE

QUARTERLY UPDATES


4.GNMA ISSUES REVERSE MORTGAGE BONDS

The U.S. Government insures about 90% of all reverse mortgages, according to the

Federal Housing Administration. Since 2003, the number of reverse mortgages that are

backed by the federal government has increased from 20,000 to 108,000 (as of 9-30-

2007). GNMA announced in early November 2007 that it will soon offer the “first

standardized” bond issue backed by reverse mortgages. The first offering is expected to

be about $120 million and will consist of more than 1,000 government insured reverse

mortgages.

REVERSE MORTGAGE CHOICES

Close to 120,000 reverse mortgages were originated in 2007, up from less than 80,000 in

2006; 90% of all such loans are insured by FHA. As the marketplace for reverse

mortgages becomes more popular, the number of lenders and product structure has also

opened up. For example, one lender has reduced the minimum age requirement from 62

to 60; another lender is going after “jumbo” reverse mortgages for homes valued as much

as $10 million (borrowers can receive up to 65% of this amount). Most reverse mortgages

are variable rate, but some institutions also offer a fixed-rate option.

Upfront fees from well-known reverse mortgage lenders such as Wells Fargo and Bank

of America can be as high as 5% or more of the home’s value. Practitioners advising

clients about reverse mortgages should ask the prospective lender what index is used for

the reverse mortgage (some use Libor and others use the CMT index, which is based on

U.S. Treasury bonds). The advisor should also find out the total amount of fees that are to

be paid.

For example, toward the end of 2007, someone in Georgia with a $500,000 house could

receive a reverse mortgage for up to $148,300 with a 7.8% loan (rough 1-1.5% higher

than a conventional first mortgage loan backed by GNMA or FNMA); the fees paid

would equal about $7,000 (or 1.4% of the home’s value). The same borrowers could get

up to $140,600 through a FHA-backed reverse mortgage, pay $13,260 in fees and receive

a 4.9% loan.

REAL ESTATE 4.2

QUARTERLY UPDATES


REIT WEBSITES

www.nareit.com

The national REIT trade group (NAREIT) provides daily market information, index data,

historical returns, updates, and real estate news.

www.investinreits.com

Operated by NAREIT, this site includes information on 200 REIT stocks, real estate

mutual funds and ETFs, as well as closed-end REITs.

www.nareit.com/portfoliomag/

NAREIT’s print publication, Real Estate Portfolio, includes stories and news about

specific REITs and information on foreign REITs.

http://biz.yahoo.com/industry/

This Yahoo Industry Center provides links to REIT company news, earnings releases,

and other information.

www.wilshire.com/Indexes/RealEstate

The latest news on stock indexes such as the Dow Jones Wilshire Real Estate Securities

Index, provided by Wilshire Associates.

www.inman.com

Headline news on the real estate industry, provided by an independent source.

www.cushwake.com

The Cushman & Wakefield website includes annually updated research reports, headline

news, industry analysis and rental/vacancy rates from around the world.

www.rer.org

The trade group, Real Estate Roundtable, represents owners of $700 billion in properties.

The site highlights the latest political and economic topics affecting the real estate

industry; website links to other industry groups are also included.

http://www.nareit.com/

http://www.investinreits.com/

http://www.nareit.com/portfoliomag/

http://biz.yahoo.com/industry/

http://www.wilshire.com/Indexes/RealEstate

http://www.inman.com/

http://www.cushwake.com/

http://www.rer.org/

4.3 REAL ESTATE

QUARTERLY UPDATES


REAL ESTATE LOSSES

A December 2007 report from the Organization for Economic Cooperation and

Development estimated that investors lost $300 billion related to real estate mortgages.

According to Stanford professor Michael Boskin, “Even if two million households facing

subprime resets reduced their consumption 25%, overall national consumption would

decrease just 0.3%. Consumer spending accounts for 70% of the GDP for the U.S.

In a December 12th

, 2007 letter addressed to The Wall Street Journal, former chairperson

of the Federal Reserve, Alan Greenspan noted: “The value of equities traded on the

world’s major stock exchanges has risen to more than $50 trillion, double what it was in

2002….The market value of global long-term securities is approaching $100

trillion….Although central banks appear to have lost control of longer term interest rates,

they continue to dominate in the market for assets with shorter maturities…The current

credit crisis will come to an end when the overhand of inventories of newly built homes

is largely liquidated, and home price deflation comes to an end. That will stabilize the

now-uncertain value of the home equity that acts as a buffer for all home mortgages, but

most importantly for those held as collateral for residential mortgage-backed securities.”

REAL ESTATE GAINS

According to the National Association of Realtors, from 2002 through the end of 2005,

the national existing median home price rose 33%. The gains for 2006 were estimated to

be in the 5% range, but the number is questionable since it now appears prices peaked

during the second or third quarter of 2006. However, even including a 2006 estimated

gain of 5%, the cumulative gain for 2002 through the end of 2006 was just under 40%.

Even strong real estate advocates and real brokers would agree that these 3-4 years have

been some of the very best for home appreciation. However, as shown by the table below,

one could make the argument that stocks were an even better option during this same

period.

Starting with 1995 year-end values, appreciation for the median existing U.S. home was a

cumulative 100% for the 11-year period, 1996 through 2006. During this same period, the

S&P 500 had a cumulative appreciation of 178%; small stocks had a total return of 321%.

REAL ESTATE 4.4

QUARTERLY UPDATES


U.S. Median Home Price Appreciation vs. Stocks [1996-2006]

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

homes 5% 5% 5% 5% 5% 6% 6% 9% 9% 12% 5%

S&P 500 23% 33% 29% 21% -9% -12% -22% 29% 11% 5% 16%

Small stocks 18% 23% -7% 30% -4% 23% -13% 61% 18% 6% 16%

The case for stocks becomes even stronger for this time frame when you factor in

the costs of homeownership (e.g., debt service, fire insurance, property taxes,

maintenance, remodeling, etc.). For example, subtracting 2% annually for homeowner

expenses (a conservative estimate since annual property taxes alone are 1-2%+ of

the home’s value), the cumulative return for median home appreciation drops from

100% down to 63%.

QUARTERLY UPDATES

CLOSED-END FUNDS

5.1 CLOSED-END FUNDS

QUARTERLY UPDATES


5.CLOSED-END FUND FACTS

According to the Closed-End Fund Association, a trade association located in Kansas

City, the first closed-end fund (CEF) was introduced in the U.S. in 1893, more than 30

years before the first open-end fund. As of the third quarter of 2007, over $350 billion

was invested in closed-end funds (CEFs), versus more than $11 trillion in traditional

mutual funds. The average expense ratio for a mutual fund is 1.29% versus 1.26% for the

average CEF.

The average U.S. household has $60,000 invested in financial assets; the average

household that owns mutual funds has a typical balance of $125,000—the average

household owning CEFs has $370,000 invested in closed-end funds. Municipal bond

funds are the largest category of CEFs ($95 billion), followed by stock CEFs ($87

billion) and U.S. taxable bond CEFs ($68 billion). As of the middle of 2007, the average

discount for a CEF was 5.6%. The IPO volume for CEFs for 2007 may reach an all-time

high, surpassing the 2003 record of $31 billion.

COVERED CALL CEFS

Since 2004, over 40 stock funds have launched a covered call, or “buy-write,” strategy;

most of the offerings have been closed-end funds (CEFs). Many of these funds that focus

on covered call writing promote their double-digit yields instead of total return. The

selling of covered calls is what generates the vast majority of the funds’ current yield.

Over half of the buy-write funds have NAVs that are below their initial offering price,

meaning capital gains have suffered. One argument against covered call writing is that

the best performing stocks get called away; a number of funds counter this argument by

selling covered calls against a market index such as the S&P 500.

Advisors who are attracted to a covered call strategy using CEFs should never buy the

IPO, since the majority of all CEFs end up trading at a discount that reflects a

commission premium (typically 4.8%) and liquidity. For example, a buy-write fund could

show a 12% annual return for the past 2-3 years but only a 7% return for initial investors

who paid a premium for the IPO. Two of the bigger participants that utilize a covered call

strategy are Eaton Vance and Nuveen.

QUARTERLY UPDATES

ETFS

6.1 ETFS

QUARTERLY UPDATES


6.MUNICIPAL BOND ETFS

The first municipal bond ETF was introduced in September 2007 (iShares S&P National

Municipal Bond Fund). Barclay’s bases this ETF on the S&P National Municipal Bond

Index of 3,069 issues with a rating of BBB- or better from at least one of the major rating

services. The Barclay’s ETF contains about 36 (7 year duration) of the 3,069 issues.

State Street’s SPDR Lehman Municipal Bond ETF is benchmarked against the Lehman

Brothers Municipal Managed Money Index; the index is comprised of over 22,000 muni

bonds rated AA3/AA- or higher. State Street’s ETF will use about 37 (8 year duration) of

the 22,000 index securities. PowerShares uses a customized Merrill Lynch muni index.

Illiquid securities can behave quite differently than liquid bonds in the same index. State

Street expects a tracking error of 0.50% to 0.75%; any “error” could either benefit or hurt

investors. The 1,929 municipal bond funds tracked by Morningstar have an average

expense ratio of 1.1%, versus 0.25% for the Barclay’s ETF and 0.2% for the State Street

ETF.

ETN RUSH

Exchange-traded notes (ETNs) and exchange-traded funds (ETFs) both track an index

and trade throughout the day. The ETN is a way for a financial institution to repackage

and sell “structured notes,” which previously were only available to wealthy investors or

institutions. ETNs do not have to adhere to some of the regulations that apply to ETFs

and traditional mutual funds. ETNs: [1] are traded throughout the day, [2] can be bought

on margin, [3] can be shorted, and [4] are registered under the Securities Act of 1933.

ETNs do not have a net asset value; their daily value is based on indexes published by the

issuer. Perhaps the biggest appeal of an ETN is that they allow investors to

participate in asset classes and geographical areas that they cannot directly invest,

due to lack of accessibility or restrictions.

Unlike ETFs, ETNs are not backed by a specific pool of assets; an ETN represents a

promise by its issuer to match the returns of a particular index or commodity. Because

ETNs are backed by the issuer’s promise, investors need to keep abreast of the issuer’s

credit rating. IF the ETN issuer had financial difficulty, investors might have to get in

line with other creditors. ETNs are considered to be “senior, unsubordinated, unsecured

debt securities.” ETNs are registered with the SEC, but do not have to comply with

Investment Company Act regulations (e.g., no board of directors is required). The tax

status of ETNs is still uncertain. The current belief is that investors should only realize a

capital gain or loss upon the sale, redemption, or maturity of their ETN. A number of

ETNs have a 30-year maturity date.

ETFS 6.2

QUARTERLY UPDATES


Because an ETN owns no securities or commodities, all trading costs can be avoided.

And, since no stocks or bonds are owned, there are no taxable distributions (the status of

this was still uncertain as of November 2007). ETNs are not actually “notes;” they are

prepaid forward futures contracts. Institutions can sell an ETN back to the issuer at

anytime; the issuer pledges to pay an amount exactly equal to the benchmark minus

expenses. Individual investors must go through a broker and pay a commission. The

typical bid-ask spread of an ETN is 5-10 basis points. The total value of outstanding

ETNs was $3 billion by the fourth quarter of 2007. The table below shows some of the

ETNs currently trading.

Name Investment Expense Ratio

iPath CBOE S&P 500 Buywrite (BWV) Covered calls 0.75%

iPath Dow Jones-AIG Commodity (DJP) commodities 0.75%

iPath EUR/USE Exchange Rate (ERO) currency 0.40%

iPath MSCI India Index (INP) emerging markets 0.89%

iPath S&P GSCI (GSP) commodities 0.75%

A number of banks are launching exchange-traded notes (ETNs): Barclays (commodities,

currency, and other investments), Goldman Sachs (enhanced commodity index), Bear

Sterns (index of master limited partnerships), Deutsche Bank (Morningstar Wide Moat

Focus Total Return Index), and J.P. Morgan Chase (commodity and other products).

FREE ETF AND MUTUAL FUND TOOLS

Fundgrades.com grades ETFs and funds ranging from A+ to F on expenses, return, and

risk. The ratings are based on a comparison between the fund selected and its peer group.

The free service also compares the ETF or fund against the broad universe of U.S. stocks.

For example, SPY (iShares S&P 500) is described as, “Almost no risk of substantially

underperforming the large-blend asset class, but a significant risk of lagging behind the

broader pool of U.S. stocks.”

Another web site, etfguide.com/beta helps investors understand the foundation of any

ETF strategy. Indexuniverse.com has a “fundamental ETF screener” that lists ETFs that

weight holdings based on fundamental factors. For advisors who cannot decide between a

mutual and ETF, the web site rydexinvestments.com (look for “investor resources”) does

a cost comparison based on how often trades are expected and commissions paid.

6.3 ETFS

QUARTERLY UPDATES


FOREIGN BOND ETFS

For advisors who wish to diversify their clients’ fixed-income or simply profit from a

falling U.S. dollar, there are ETFs that are based on foreign government bonds. The

SPDR Lehman International Treasury Bond ETF (BWX) is based on a Lehman Brothers

index of government bonds of 18 countries denominated in 11 currencies.

QUARTERLY UPDATES

MISC.

MISC. 7.1

QUARTERLY UPDATES


7.NO OIL SHORTAGE

As of November 2007, the amount of oil in storage tanks around the world was 4.2

billion barrels. According to British Petroleum, the world’s proven reserves are

now 1.4 trillion barrels, up 12% in the past 10 years. Additionally, there is an

estimated 1.7 trillion barrels of oil that can be extracted from Venezuela’s Orinoco

tar sands. Combined (1.4 + 1.7 trillion), this represents 100 years of production at

current rates. There are now 45% more oil rigs in service today than there were

three years ago.

It is estimated that it costs Saudi Arabia $4-$5 a barrel to produce a barrel of oil.

The full cost of new production, even in a “challenging” area such as Canada’s oil

sands is about $30 a barrel. Iran is not likely to end exports, which account for

50% of their GDP and 90% of its hard currency earnings.

HEDGE FUND TRADING

As the list below shows, hedge funds are responsible for quite a bit of the trading

activity for a number of securities and derivatives. Sometimes, these unregulated

pools of capital are responsible for more trading than banks, mutual funds, or

insurance companies. The figures below come from a 2007 study by Greenwich

Associates, who polled 1,333 U.S. institutions, questioning them about their debt

instrument trading.

Hedge Fund Debt Trading

Asset % of total trading volume

emerging markets debt 55%

Investment-grade derivatives 55%

Junk rated derivatives 80%

Distressed debt 85%

All fixed-income 30%

7.2 MISC.

FUND CURRENCY HEDGING

Most mutual fund prospectuses give funds quite a bit of leeway when it comes to

currency hedging. The majority of international funds, including Fidelity,

American Funds, and Vanguard index funds, do no hedging. Some fund families,

such as Janus, Oakmark, and First Eagle, have flexible hedging policies. For

example, management at First Eagle have no view on currencies so they split the

difference between the two extremes and hedge about 50% of their overseas

portfolios. Still other fund families, such as Tweedy Browne, Longleaf Partners,

and Mutual Series are either mostly or fully hedged all the time.

CORPORATE PROFITS

Over the past 25 years (1982-2006), the economy’s average annual growth rate

has been 5.9%, versus a 10.3% annual appreciation rate for S&P 500 stocks; if you

add dividends, the annualized return for the S&P 500 has been 13.4%. In 2006,

corporate profits represented 13% of national income, versus 9% in 1990 and 7%

in 1982. The last time such profits represented 13%+ of the economy was in 1965.

S&P 500 companies receive 40% of their earnings from abroad. However, the

surge in earnings has also come at the expense of employees. The percentage of

corporate profits going to employee wages and salaries has dropped from 56% in

1980 to 52% in 2006. All of this suggests corporate profits will likely slow in the

future, meaning advisors may want to consider increasing their clients’ exposure

to bonds, cash equivalents, and foreign equities.

PRESCRIPTION DRUG COVERAGE

Roughly 24 million seniors and others eligible for Medicare benefits have signed

up for the Medicare drug benefit. The average monthly premiums for the top three

Medicare drug benefit plans are expected to rise to $29 in 2008, representing an

increase of over 25% from 2007. The average 2008 premium among the top 10

carriers are expected to range from $20.70 to $40.35 per month. Many plans will

require those covered to shoulder a larger share of the cost of drugs covered.

However, a few insurers are lowering their fees for 2008. United-Health Group

and Humana control about 44% of the drug-benefit market.

MISC. 7.3

QUARTERLY UPDATES


When advising your clients about this benefit, compare monthly premium costs,

the list of drugs covered by the insurer as well as the cost-sharing requirement.

The class of drugs most severely affected in 2008 is “nonpreferred” brand-name

drugs (e.g., Zocor and Celebrex). Medicare offers online tools

(www.mymedicare.gov or www.medicare. gov) that include report cards that rate

plans based on a number of factors, including customer service, drug pricing, ease

of getting a prescription filled, out-of-pocket cost comparisons, and pharmacy

networks in the area. Information can also be obtained by calling 1-800-medicare.

RATING HOSPITAL CARE

One of the best sources for hospital data is www.hospitalcompare.hhs.gov.

Hospital Care is a web site set up by the federal Centers for Medicare and

Medicaid Services, hospitals, and other groups. Your clients can search by city,

state, or other criteria and compare more than 5,000 hospitals against one another.

Much of the “best practices” data provided by Hospital Care comes from Medicare

data and focuses on three of the most common areas of hospital care: heart attack,

pneumonia, and surgery. The table below provides a list of resources to help the

advisor find quality hospitals.

Hospital Care Online Sources

Source Description

Hospital Compare

www.hospitalcompare.hhs.gov

Hospital adherence to practices that improve patient

care—no rating on how well patients do after treatment.

Leapfrog Group

www.leapfroggroup.org

Consistency of how 1,300 hospitals follow 30

practices—only covers a fraction of the country’s 6,000

hospitals.

Nat’l Assoc. of Health Data

www.nahdo.org/qualityreports.aspx

Which states provide consumer-friendly hospital data—

no link to a state agency’s web site.

Agency for Healthcare Research

www.talkingquality.gov/compendium/

Links to state agencies offering reports, databases, and

other information on hospitals and health care

organizations—some information is dated.

Health Grades

www.healthgrades.com

Compare 5,000+ hospitals on 32 conditions and

procedures, including complications and death rates—

much information is free, but extensive reports are $18

Dartmouth Atlas

www.dartmouthatlas.com

How hospitals care for patients shortly before they die,

including hospice transfers and time spent in ICU—

very detailed data makes searches complex.

http://www.mymedicare.gov/

http://www.medicare.gov/

http://www.hospitalcompare.hhs.gov/

http://www.leapfroggroup.org/

7.4 MISC.

LONGER LIFE EXPECTANCY

A big mistake retirees make is underestimating their life expectancy. According to

2000 Census and American Society of Actuary data, there is a 25% chance that a

65-year-old couple will see one spouse live to age 97. According to the

Department of Biological Sciences at Stanford University, it is estimated that life

expectancies will increase by 20 additional years between 2010 and 2030,

assuming anti-aging therapies become widespread.

Documents

IBF - Updates - 2007 (Q4 v2.0)